Sunday, February 24, 2019

Lessons from the Great Depression: Monetary Policy and the Federal Reserve System (Part 3 of 4)

Click here to read the original Cautious Optimism Facebook post with comments

7 MIN READ – The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff continues his series on Federal Reserve policy during the Great Depression with a greatly depressing account of Fed inaction during the worst financial crises in American history.

The story of the Federal Reserve’s policy blunders of 1929-1933 is one of the most complex analyses in this series of Great Depression columns requiring multiple, interdependent installments. To read prerequisite Parts 1 and 2 of the series go to…

Part 1

Part 2


While the Fed’s alleged failures in managing the monetary base are still debated (it didn’t do enough, but the data show it clearly did not contract the monetary base), its performance as lender of last resort is almost universally condemned.

As we discussed in Part 1, the primary reason the Fed was established in 1914 was to act as lender of last resort (LOLR). During pre-1914 panics larger private banks had tried as best they could to carry out the LOLR role for smaller banks, but were limited by legal unit banking restrictions which fragmented the system into over 25,000 small local banks, 95% of which had no branches (Calomiris).

When the Panics of 1930, 1931, and particularly 1933 struck, most American banks were still solvent. That is, even in the midst of severe depression, their loan portfolios and other assets were worth more than their customer deposit liabilities. However as their customers increasingly panicked and pulled cash and gold from the system, the quantity of liquid reserves (ie. cash) contracted quickly.

Hence the time had come for the Federal Reserve to step up and carry out the very policy it had been created to implement: to act as LOLR and make emergency cash loans to banks to shore up their liquidity which the banks would repay once depositor hysteria had subsided.

Instead, as we’ve alluded to earlier, the Fed did nothing. It sat by and watched as hundreds, then thousands of perfectly solvent banks ran out of cash and failed.

The results were devastating as we shall see in a moment. But why did the Fed do nothing?

The Fed’s governors had plenty of time to consider their policy. The first banking panic struck in the fall of 1930, after which the Fed had nearly a year to consider its LOLR policy before the next panic which began in late 1931, and more than a year to consider again until the final, calamitous panic of February/March 1933.

Yet even with over two years between the first and last panics of the early 1930’s, Fed officials still elected to do virtually nothing when the most destructive crisis engulfed the nation in early 1933.

It’s no coincidence. The Fed’s hands-off response was a direct reflection of its own policies, two of which we will mention here.

First, as we discussed in Part 2 the Fed had been governed by the now defunct “Real Bills” doctrine of monetary policy. That is, the Fed was run by officials who believed short-term loans to commercial banks should not be made unless the money was to be used towards business activity that would create a corresponding increase in real goods and services. This lending practice would be reflected by the banks’ holdings of short term commercial paper (hence the name “Real Bills”). Or another way of considering Real Bills is that the Fed refused to expand the money supply further than the rate at which the real economy was expanding lest they feared they might stoke inflation. Ironically the economy was contracting in the early 1930's so consistent with its own doctrine the Fed pursued a perverse contractionary monetary policy.

Many banks in 1930’s America were rural unit banks that loaned to farmers. Their notes were not the kind short-term commercial bills Fed officials deemed necessary to collateralize LOLR discount loans. Also many banks holding short term commercial paper were asking for LOLR loans simply to replenish customer cash withdrawals, not to make new loans for real economic-expanding ventures. Hence the Fed refused to make LOLR loans to thousands of institutions—a death knell during a crisis for banks that would otherwise have survived.

Second, the Fed had frowned upon speculation. Thus the Fed adopted a “direct pressure” policy towards member banks applying for loans and reserves that it perceived had previously financed stock market or real estate speculation. The policy forced banks into a lengthy and overburdensome application process that often triggered an even more lengthy cross-examination designed to discourage application and in most cases simply being denied (Timberlake).

So again, as member banks lined up for LOLR loans the Fed discouraged or outright denied them due to what it considered irresponsible behavior, even if their portfolios were still solvent. The result was predictable: thousands of unnecessary bank failures ensued.


By March of 1933 newly inaugurated President Franklin Roosevelt had declared a national banking holiday and Congress was taking up new emergency measures to stabilize the financial system.

As previously mentioned, over 10,000 banks had failed (compared to zero in Canada which had no central bank until 1935) taking the deposits of millions of Americans with them.

The aftermath was unprecedented in American history.

First, to state the obvious, when over 10,000 banks fail and the remaining banks are on life-support, the credit-issuing mechanism of the financial sector freezes up. Businesses and farmers can’t get credit which is the lifeblood of the economy. Such credit crunches inflicting the U.S. in pre-1914 banking panics were responsible for the recessions that followed afterwards.

But during the 1930’s the seizing up of bank credit was compounded by nearly unprecedented deflation. 

The overall money supply as measured by both M1 and M2 fell by a third, from approximately $47 billion to $32 billion (M2 source: North-Mises Institute, Wheelock-St Louis Federal Reserve. See attached chart, green line). As a result, prices fell by nearly 30% as well and the deflation boosted the purchasing power of the dollar by 40%.

With the dollar gaining value so rapidly, the real value of debts and interest payments rose accordingly. Prices and revenues fell due to deflation, but businesses, farmers, and individuals found it difficult or impossible to pay or service loans that remained in constant pre-1929 dollars. If you can imagine as an individual your mortgage, auto, and credit card loan payments going up by 40% in two or three years you have some idea what uphill battle debtors face during periods of rapid deflation.

The result was bankruptcies that spread throughout the nation.

Those bankruptcies resulted in more loan losses and exacerbated bank failures in a vicious cycle that American economist Irving Fisher dubbed the “debt-deflation spiral.”

Also as prices fell rapidly, consumers and businesses that were already reluctant to spend on consumption and investment tended to hoard in anticipation of their money being worth more in the near future. While theories of deflationary hoarding are generally invalid during periods of gentle, secular deflation (such as the 1865-1914 period marked by rapid increases in productivity and falling unit costs), the deflation of the 1929-1933 was so extreme that it induced widespread hoarding.

Individuals are unlikely to defer purchases simply because their money will be worth 0.5% or 1% more in a year or two, but if their money is worth 40% more in two or three years, especially while a frightening depression and major banking panics are underway around the nation, people absolutely will feel compelled to withdraw and hoard every dollar they can.


Furthermore while deflation alone was bad enough, deflation combined with government price controls precipitated mass unemployment. Shortly after the 1929 stock market crash President Herbert Hoover pressured American businesses to maintain their 1929 nominal wages. His belief was that high purchasing power and the demand it spurred would end the depression within months.

But businesses found themselves paying workers 40% more in real terms even as depression sapped their sales and debt/interest payments rose by the same 40% in real terms. So as the deflation relentlessly raised the worker wage floor corporate managers were forced to lay off millions. By the end of 1931—even before the worst of the banking panics—unemployment already stood at 15.8% and it peaked at 26% in 1933.

For more on Herbert Hoover’s high-wage policy see CO’s “Lessons From the Great Depression: Wages” at:

On a side note I’ve alluded twice to the “nearly unprecedented” deflation of 1929-33 during which the U.S. money supply and prices contracted by approximately a third. 

However what’s little known is that during the post-panic slump of 1839-43 U.S. prices also fell by approximately a third (Hummel). 

But unlike the Great Depression, the four year period of 1839-1843 produced an annual real GDP growth rate of about 4% (Bordo, Rothbard) and full employment by the final year of 1843. By contrast during the 1929-1933 deflation, unemployment reached 26% at the end of the four year deflation and real GDP fell by about 30%.

Why the enormous difference in economic performance despite both periods producing roughly the same severe deflations? Unlike during the Hoover years where wages and prices were kept tightly controlled and downwardly rigid, wages and prices were free to adjust during the 19th century allowing goods and labor to clear the market more rapidly via the classical model. 

Ironically, flexible prices and wages stem from the same classical model that John Maynard Keynes argued was invalid in his book “The General Theory of Employment, Interest, and Money” and which Keynesians continue to criticize today. Instead, both Keynes and his modern day disciples argue for government action to artificially raise  prices and wages to boost aggregate demand, a policy that Herbert Hoover followed faithfully to the country’s miserable detriment.

Finally a word about aggregates: M1 and M2 both fell by nearly a third, but the Federal Reserve gold stock and monetary base (see attached chart, blue line) actually rose slightly from 1929 to 1933. Why such a divergence?

The answer leads us to our conclusion. The 1930’s great contraction of the money supply and prices was not due to a deliberate contraction of the monetary base by the Fed, but rather its failure to counter bank failures by providing solvent banks with new reserves. As gold flowed into the U.S. the Fed tragically sterilized it. As banks approached the Fed for new reserves they were rejected because their paper assets didn’t qualify under the discredited Real Bills Doctrine. And as solvent but cash-strapped banks approached the Fed's discount window for LOLR short-term liquidity loans Fed officials turned them away for the same reason.

On the biggest, most critical policy decisions the Federal Reserve failed on three out of three.

Had the Fed simply made new reserves available to banks in exchange for their assets, or at the very least provided new reserves with LOLR loans (ie. carried out the role it was created to conduct in the first place), widespread bank failures would not have ensued nor would have the subsequent banking panics those failures triggered.

On a related note, the stage for the beginning of the 1929 slump that precipitated the tragedy of the next four years was itself also set by the Fed with its then-unprecedented QE that fueled asset speculation and overinvestment in a late 1920’s boom and bubble. 

So the Fed not only started the fire with interventionist policies in the late 1920’s, it also added fuel to the fire by sitting on its hands in the 1930’s.

You can read more about the Fed’s 1927-28 QE and the Bank of England’s analogous gold-exchange experiment at:

Part 1

In the upcoming final installment we will review FDR’s New Deal remedies for the monetary collapse and how lessons learned from the Fed’s mistakes of the thirties guided Fed policy during the 2008 financial crisis.

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